Investments, tenth edition

  Determinants of Option Values 

 We can identify at least six factors that should affect the value of a call option: the stock 

price, the exercise price, the volatility of the stock price, the time to expiration, the inter-

est rate, and the dividend rate of the stock. The call option should increase in value with 

the stock price and decrease in value with the exercise price because the payoff to a call, 

  

1

 This discussion presumes that the stock pays no dividends until after option expiration. If the stock does pay 

dividends before expiration, then there  is  a reason you would care about getting the stock now rather than at 

expiration—getting it now entitles you to the interim dividend payments. In this case, the adjusted intrinsic value 

of the option must subtract the value of the dividends the stock will pay out before the call is exercised. Adjusted 

intrinsic value would more generally be defined as  S  

0

   2  PV( X )  2  PV( D ), where  D  is the dividend to be paid 

before option expiration. 

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Final PDF to printer

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P A R T   V I

  Options, Futures, and Other Derivatives

if exercised, equals  S  

 T 

      2     X.  The magnitude of the expected payoff increases with the 

difference  S  

0

   2   X.  

 Call option values also increase with the volatility of the underlying stock price. To see 

why, consider circumstances where possible stock prices at expiration may range from $10 

to $50 compared to a situation where they range only from $20 to $40. In both cases, the 

expected, or average, stock price will be $30. Suppose the exercise price on a call option is 

also $30. What are the option payoffs?